Fixed index annuities were introduced to the insurance world in 1995 and have quickly become one of the most popular retirement products in the United States. FIAs have many similarities with variable annuities. They are an annuity product that is attached to a benchmark index like the SP500. The major difference is that FIAs have many different ways to structure rates and returns making them a surprisingly complex product. Most FIAs are subject to rate floors as well as rate caps. The basic reasoning behind an FIA is simple. Investors always want the upside of the market but hate the downside; therefore, FIAs give you a percentage or cap the upside while giving you complete downside protection. If the benchmarked index is negative then the principle does not decrease and neither does any earnings. The insurance company will bear all of the volatility and downside risk.
What are the typical rates?
FIAs may have different levels of floor and cap rates. The two ways an investor may see the upside rates represented is a cap rate and participation rate. Cap rates are a simple ceiling usually anywhere from 3-7% depending on the annuity and they pay out on the anniversary date of the annuity. If the market benchmark chosen has performed well for that time period then the investor will receive a maximum of the cap rate. That investor will also still be safe from the downside risk. Participation rates are slightly different. The participation rate typically takes a percentage of market gains anywhere from 40-65%. These are structured to let an investor benefit from a great bullish market but when the market gives low returns it may not be as beneficial. Basically, if the market makes 20% in a year and the participation rate is 50%, you will be credited 10% in interest. Therefore there is no limit to your interest like a cap rate; however, low market returns could be frustrating. Some annuity products offer floor rates that guarantee 1-3% interest no matter how the market performs. It is important to review the annuity market to make sure you are getting the best product. Since annuities are not securities they are regulated at the state level and most states require insurance companies to give a free look period. A “free look” period allows the investor 30 days to rethink the decision and if that person chooses to get a full refund there is no penalty.
Why could this be for me?
The first major benefit of purchasing an annuity is a benefit that many overlook during retirement, taxes. If an annuity is purchased with after-tax dollars then those earnings grow on a tax-deferred basis and are not paid until withdrawal. If the annuity is purchased using rollover funds from a 401-k or an IRA then different tax rules would apply. The earnings will not offset social security benefits during retirement as happens sometimes with earnings on bonds. Another benefit comes from a wide variety of high rates. The rates of FIA often beat CDs and bonds making them a much more attractive option for investments. Often insurance companies will compare annuity performance to market performance; however, unless the investor is simply indexing one’s equity funds then it is an inadequate comparison. The better comparison lies in the fixed income and money markets. FIAs are competitively priced and actually do better when FED interest rates increase.
One thing investors must consider is expectations, even though their downside is protected they should not expect massive year over year returns. FIAs were designed as a way to provide safe capital growth that could lead to pension like retirement income. They help avoid major equity losses during recessions and are one of the leading ways to avoid losing money in retirement. Many annuity holders purchase an Income Rider with a GLWB. GLWB stands for Guaranteed Lifetime Withdrawal Benefit. It is a rider that ensures an income for your remaining lifetime whether the principle runs out or not and is backed by the financial health of the insurance company. Due to the complexity and the sheer number of options in the FIA market it is important to have somewhere to go to find clarity. https://annuityusa.com/ is a website that can provide clarity on the different kinds of annuity products and solutions to any issues an investor may have with current annuity products. It is important to consult a financial advisor to make sure your annuity is efficient and built to fit your needs.